Month: August 2011

The following is an interview I had with Capital Wave Forecast editor and former hedge fund manager Shah Gilani:

Q: What are the chances for a true crash?

Gilani: A potential for a crash always looms out there. Unless the Fed comes to the rescue, we could get what didn’t happen last year. Last year, a crash was staved off because of the QE2 announcements. Ironically, the market was down 256 points almost to the day last year. We’ll have to see if the Fed comes to the rescue this year. Unfortunately, we never know which card the Fed is playing. It’s like a game of Three-card Monte.

Q: What would happen if the Fed intervenes?

Gilani: The markets could take off if that happens. People might be thinking: I missed last year. It could be like hearing a starter pistol, and the train is the Fed with a handful of cash. So people would jump back in, and we could see a big pop in the market. If you’ve got the backing of the Fed, you jump in with both feet.

The market has gone up because of the monetary stimulus since February 2009. Where did that stimulus go? It didn’t go to building infrastructure. It was used to bail out the banks. The Fed gave the money to the banks so they could rebuild their balance sheets. The Fed wanted the banks to get healthy again. And where did all that short term money go? To the stock market! And to buying commodities. The Fed engineered a stock market recovery. The idea was to create confidence and improve investor sentiment.

Q: Is there a downside to QE3?

Gilani: The downside is if the Fed threw a party and no one came. The negative is if it doesn’t work.

Q: What strategies should you use?

Gilani: First, you should be nimble. Read economic data. Everyday it comes out, read it. Be quick on the trigger and get out. If the Fed makes a move, get out of that train and switch gears.

If you’re an investor, you have to be defensive. There is always time to make money and to get back in. It’s now a stock picker’s market. I want to be in stocks that have plenty of cash flow, has global reach, and supports a nice, fat dividend. I’m not looking for high flyers but stability and preservation of capital.

Q: What else should you buy?

Gilani: If you have money, apply it to strong, international companies with good dividend yields. I like Merck, Rathion, and Microsoft.

Q: Are you nervous about September and October?

Gilani: Always! Especially this September and October. If the Fed doesn’t come in soon, I’d be concerned if the economy doesn’t show better numbers, and if the global markets slow down and pull back.

The following is an interview I had with blogger and professional short-seller Timothy Sykes:

Q: What should someone do right now?

Sykes: The odds favor doing nothing right now. The downside is so massive. If we can’t hold 11,000, it could start momentum. It could be a 10% off sale and people could pile in.

Q: What is so important about Dow 11,000?

Sykes: If 11,000 cracks, then we can see some true panic. Remember, this is just August. We didn’t plan on this. In all likelihood, this is just a precursor to a lot of trouble heading into September and October. We raised the debt ceiling but it’s only good to the end of the year. All we did was stall the inevitable. I don’t expect us to rebound to the highs and break out. Right now, all the momentum players are scared. You can be a dip buyer and make a few points here and there.

Q: Should you short this market?

Sykes: I never short market drops because it’s so difficult. Right now, it’s tough to short down here. The only angle I see is selectively buying strong stocks. You buy into strength and you short into individual strength. I short sell individual stocks that are being manipulated, but I don’t short the whole market.

I also like to trade overreactions. I find that whichever way the market is going, it tends to overreact. So I think we’re going to overreact on the downside. If we overreact in a bull market, people spend more because they’re happier. You have to be extra careful when the market is going down, like now, because a crash could lead to a depression.

Q: How about going long?

Sykes: I wouldn’t build long-term positions on either side right now. It’s better if you trade like a sniper, and be picky. The market is volatile right now. The fundamentals are saying we’re doing great, but the economy is saying we’re doing poorly. On the technical side, the charts are saying you should go short, but a long term short has never worked out well. So we have opposing sides. There is no consensus.

Q: What else should you watch out for?

Sykes: Watch out for earnings losers because they will get smacked the most in this environment. Dump any speculative stocks and focus on earnings winners. Stick with companies that have proven themselves. If the market moves higher, these stocks should move higher. Right now I like Rosetta Stone.

Q: What kind of trader are you?

Sykes: I like to trade like a coward. It’s not about who can make the most money the quickest, but who can employ risk management techniques to focus on survival and consistent profits. The idea is to remain liquid coming into these crashes. By managing my risk carefully and cutting losses quickly, I am not afraid. I’m always thinking of safety first, because it always protects me, even if I miss out on opportunities.

MIAMI (MarketWatch) — For years, people have been warning of an impending stock-market crash. Those who listened buried their money in short-term bonds or cash and missed out on one of the greatest comebacks in market history.

The purpose of this article is to help traders and investors understand the clues and psychological characteristics that often precede a market crash. No one can predict the day or time, but if you pay attention, you can recognize the signals.

Clue no. 1: Leading stocks fall

This comes from “How To Make Money In Stocks” by Investor’s Business Daily founder and Chairman William J. O’Neil. If leading stocks such as Priceline.com Inc., Amazon.com Inc. and Apple Inc. start to break down and fall, this signals that the market is weakening and that the market’s dynamics are changing for the worse.

In addition, after the recent two-year bull market, expect choppy conditions moving forward, which increases the risk there could be a correction or crash. Bottom line: Pay attention to leading stocks.

Clue no. 2: September-October curse

Historically, most crashes occur in September and October. If you’re in the stock market, you must be acutely aware of these two months and be prepared for potential crashes. Because traders with trigger fingers know about the September-October curse, fear often increases during these two volatile months.

Clue no. 3: Speculation is rampant

Who can forget the crazy days of 1999 when Internet stocks like Qualcomm Inc. went up by 100 or more points in a day? My favorite example is the 17th-century tulip mania, when thousands of Dutch people paid more than $200,000 (using today’s exchange rate) for a single tulip bulb.

Although the current market environment is not that speculative, there are clues that some stocks are flying into the stratosphere. “You could make the case that the current valuations of Twitter, Facebook, LinkedIn, Pandora and Zillow are extreme,” says Timothy Sykes, professional trader and short-seller. “These companies have amazing business models and people think their businesses will never stop growing, but that is just bull. The odds are that Facebook’s valuation will see $60 billion valuation (currently $80 billion) before it sees $120 billion.”

Clue no. 4: Media doom and gloom

When the media begin to report that the market has been falling for a record number of days (i.e. “down for fifth straight session”), it makes people anxious. “It causes people to want to exit en masse,” says Sykes, “like a run on the bank. They are being influenced by fear.”

In addition to the above clues, it’s also important to study crash characteristics.

Characteristic No. 1: The catalyst

There is usually a big event that takes a weakened market lower. This can be the catalyst that causes the crash.

“Crashes don’t usually happen out of the blue,” according to Sykes. “Sometimes they do, but most crashes occur when the market is already downtrending.” He says that people are already selling into a downtrending market when they “suddenly puke it up one day. The momentum that causes a crash is built up over days, weeks or months.”

The most dangerous market is a long and gradual downtrend where there are no bounces. This can lead to a severe crash.

Note: The current market remains in a two-year uptrend, although it has been struggling lately.

Characteristic No. 2: The big bounce

As you probably know, the two big motivators in the stock market are fear and greed. Although greed can go on indefinitely, most people don’t remain in a perpetual state of fear for long. That is why after a big crash, there is often a big bounce. “Every crash throughout history has been followed by a bounce, no matter how fleeting,” says Sykes. “It might not be huge or long, but if you can sit in cash while everyone else is panicking, you have an opportunity.”

Flash crashes, although rare, can create the biggest bounce, he added.

Characteristic No. 3: Crashes rarely happen at tops

Most people think the market hits some magical number, like the Dow Jones Industrial Average at 13,000, and then crashes. This myth has caused people to miss out on many financial opportunities. “People love calling the top,” says Sykes, “because they think there will be a crash from the top. The market might fail to break out to new highs, but crashes usually don’t happen at the top.”

A more likely scenario, he remarked, is there’s a drop before the crash. “This scares the momentum buyers away, which can then lead to a crash.”

For example, it took 17 months for the blue-chip index to fall from 14,164 in October 2007 to 6,469 in March 2009. The most severe damage to the market lasted only five months beginning on Oct. 1, 2008, when the Dow already had fallen to 10,850.

Understanding the characteristics and clues of market crashes is essential for traders and investors. It’s also important to have a plan before the next crash occurs, which will be the subject of my next article.

Michael Sincere is the author of Start Day Trading Now (Adams Media, 2011), All About Market Indicators (McGraw-Hill, 2010), and Understanding Stocks (McGraw-Hill, 2003).

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